Educational Articles

Target-Date Mutual Funds — Proceed With Caution

Robert J. Adamski
| June 17, 2009

Target-date mutual funds have been the subject of much scrutiny over the past weeks and months. These funds are generally meant to be the sole holding for an investor, providing a diversified mix of assets that change over time, becoming more conservative as the “target date” draws near. In general, the “target date” is expected to be the investor’s retirement date. The general logic of these offerings is to do for investors what they may not be able to do for themselves—provide diversification/asset allocation and a structured investment program that changes (becomes more conservative) as the investor ages.

Still, there is a great deal of variability in the portfolios of target-date funds. For example, Senator Herb Kohl, the Chairman of the Senate Committee on Aging, investigated these types of funds and found that a collection of 2010 dated funds had stock allocations that ranged between 8% and 68%. The U.S. Labor Department is also conducting an investigation, as it attempts to determine if these types of funds have exposed investors to too much risk.

Although it is difficult to determine if a fund exposes investors to too much risk without examining their entire portfolio, it seems odd that a fund that, ostensibly, is being sold to people looking to retire in 2010 would hold nearly 70% of its assets in equities. On the flip side, a similar fund with just 8% of assets in equities would likely be too conservatively invested. Note that just a few years ago many of these funds were widely considered to be too conservatively positioned, causing some management teams to increase the equity allocations of their target date funds.

Considering both the variability between target date funds and the flip-flopping concerns about their structures, comparing these funds to an objective, third-party allocation model would seem appropriate before a purchase decision is made. Indeed, selecting this type of fund in a vacuum would be short sighted.

Value Line’s asset allocation model, for example, would place a 2010 fund in the short-term column of the model, with three variations based on risk (low, moderate, and aggressive). Interestingly, the most conservative portfolio allocation in the Value Line model calls for no equity exposure with virtually all of the assets in cash and short-term investments. The moderate risk portfolio recommends 25% of assets in equities, including 13 percentage points in developed and emerging foreign markets. The most aggressive portfolio calls for 36% of assets in equities, with 19 percentage points in developed and emerging foreign markets.

By Value Line standards, holding nearly 70% of assets in equities for a 2010 target date fund would be too aggressive. However, for risk averse investors, 8% may not be a bad choice. Note that, assuming a retirement age of 65, most would have 20 years of life left at retirement, so an 8% allocation to equities would materially increase the inflation risk in a portfolio.

All of this being said, there are many options between the 8% and 70% equity allocation figures available to investors who wish a target date fund. In fact, the actual assets within each of these funds is generally quite different. What the current scrutiny, and the comparison to an independent asset allocation model such as Value Line’s, suggests is that you must be willing to get under the hood and learn what a fund is doing and why. Only then can you determine if the fund is appropriate for your needs. The other option, of course, is to simply do it yourself using tools like Value Line.